Shadow banking system needs a regulatory framework

It was once thought that regulation had solved the problem of financial instability. But as the crisis of 2008 showed, the regulators were fighting the last war. They still are, to a certain extent, and there is a need for them to get up to speed on current conditions in the financial industry before any more turmoil erupts. This is the conclusion drawn in “Combatting the Dangers Lurking in the Shadows: The Macroprudential Regulation of Shadow Banking,” a C.D. Howe report just released by professor David Longworth, former deputy governor of the Bank of Canada.

Reserve requirements on bank capital and liquidity, along with deposit insurance, produced many decades free of the kind of bank runs (mass withdrawals of deposits) that helped tip the world into the Great Depression of the 1930s. Yet, outside this regulatory framework grew a now substantial shadow banking sector where credit intermediation is occuring without oversight. (The shadow banking system includes finance companies, commercial-paper issuers, money-market funds, the securitization process, and repurchase (“repo”) markets for short-term financing of securities.) In the case of the 2008 financial crisis one result of this kind of credit intermediation was the runaway securitization of mortgages and a consequent boom in the housing sector, followed by a painful contraction.

Writes Longworth, “Since the 2008/09 financial crisis, the international regulatory community has taken steps to reduce the probability of future significant financial instability. So far, the emphasis has been on tougher capital and liquidity regulations for banks and greater transparency for financial products, and greater regulation of financial infrastructure such as central counterparties. …”

However, he argues that financial regulators need to turn their attention more to the potential threats lurking in the shadow banking system. And they are significant, given the size of shadow banking activities. According to Bank of Canada statistics (end of 2011), shadow banking totalled $868 billion—spread out over finance company loans ($95 billion), commercial-paper issuance ($54 billion), money-market funds ($35 billion), securitized instruments ($39 billion), and repo markets ($645 billion).Like banks, these activities should also face capital and liquidity requirements. And there is also a need for regulation in particular areas, such as the banks’ links with shadow intermediaries and the ratings process for securitized products.

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